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State Name: Connecticut
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State Abbreviation: CT
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The recent drop in rates has created some
interesting situations in the market, especially for lenders. First of
all, I'm not aware of any consensus on how to calculate a "current
coupon" rate in this environment. The current coupon is calculated by
interpolating between coupons that are above and below par, adjusting
for the delay days associated with the securities in question.

Let's take an example from the old days when
coupons traded below par. Let's assume the following, assuming (for
simplicity's sake) that we're calculating the current coupon for
February settlement, with FN 3.0s at 99.00 and FN 3.5 at 101.25. First,
you have to adjust for the delay days. Fannie Mae pools pay on the
25th of the month following the record date, which results in a 24-day
delay. (The delay results from all the accounting and financing
complications involved with managing the vast numbers of loans in the
MBS universe.) The prices can be adjusted for the delay by adding 24
days of coupon payments. For a 3% pool, the price is adjusted higher by
0.20 (i.e., 3.0 x 24/360), resulting in a 99.20 adjusted price; the
3.5% pool has an adjusted price of 101.2333. You would then interpolate
between the two prices to get the rate that equates to par. In this
case, it is 3.1967%. The last adjustment is to convert it from monthly
yield (since MBS pay monthly to a semi-annual bond equivalent yield,
which result in a current coupon rate of 3.218%.

However, we are in a world where the lowest
tradable coupon (30-year 3.0s) is both highly illiquid and well above
par. In past periods of low rates, the practice would be to extrapolate
(rather than interpolate) to par. This looks like what some people are
doing; however, it gives you some very bizarre numbers if you try to
track this number (or look at the current coupon spread over Treasuries
or swaps). A major provider shows the current coupon rate rising on
Thursday from 2.52% to 2.70%, even though MBS prices were higher on the
day. This in turn means that the spread of the current coupon over the
10-year Treasury yield, a closely-watched benchmark, has fluctuated this
week between +65 bps and +88 bps with minimal change in MBS relative
value. As they say...go figure.

The huge run-up in MBS prices has impacted the
market in other ways. Matt Graham wrote about the liquidity (or lack of
liquidity) in 30-year 3.0s. As
he noted, some lenders are originating loans that would be securitized
as 30-year 3.0s (as well as 15-year loans that would go into Dwarf
2.5s), although it's unclear what's being done with the loans. (They
could be sold to the GSEs' cash window.) With rates pushing down, a
3.75% loan can still be pooled into a 3.5% security (with a proviso-see
below); however, the poor execution on 3.0s, and lenders' unwillingness
to short the coupon, has been an impediment to rates moving even lower.
For example, the spread between the Freddie Mac survey rate and the
10-year Treasury yield is at +204 basis points, versus an average (over
the last two years) of +162.

The "stickiness" of rates at current levels is, in
my mind, largely a function of having limited outlets for loans with
note rates of 3.625% and lower. The biggest problem is that there is no
natural buyer for 30-year MBS with 3% coupons. I've recently written
that the Fed should buy all outstanding 3% pools, which would do more
good than just "buying the market." In any case, markets for these very
low coupons need to develop for rates to move decisively lower.

Another complicating factor is the impact of the
recent tax on mortgages, paid as a 10 basis point addition to a loan's
guaranty fee. Consider the above example on pooling 3.75% loans into
3.5% pools. It's almost certain that the new g-fee can be bought down
entirely (although there has not yet been a definitive statement to that
effect from Freddie or Fannie), leaving 25 basis points of servicing to
be held by someone. A question that the GSEs are grappling with,
however, is the cap on agency buy-ups. Most contracts are written such
that the total amount that can acquired by the GSEs on any loan
(including both the g-fee and servicing) is capped at 37.5 basis
points. This means that the 10 basis point tax limits the amount of
servicing that the GSEs can buy as part of the pooling transaction.
While buy-ups have not been a big factor in the past (since most big
lenders just held excess servicing, rather than sell it to the GSEs at
puny multiples) this could be a factor in the future, especially in
light of the shrinking number of players willing to take down
servicing. Supposedly, the GSEs are looking at increasing the caps,
but it's unclear whether the contracts will (or can) be revised.

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About the Author

Bill Berliner is Executive Vice President of Manhattan Capital Markets, and runs its advisory business. He focuses on working with mortgage originators on issues related to pipeline hedging, asset valuation, and business management issues.
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